CHAPTER 11
Decision Making
and
Relevant Information
Decision Models
 A decision model is a formal method of
making a choice, often involving both
quantitative and qualitative analyses
 Managers often use some variation of the
Five-Step Decision-Making Process
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Five-Step
Decision-Making Process
Step 1:
Obtain
Information
Step 2:
Make
Predictions
About
Future
Costs
Step 3:
Choose
An
Alternative
Step 4:
Implement
The
Decision
Step 5:
Evaluate
Performance
Feedback
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Relevance
 Relevant Information has two characteristics:


It occurs in the future
It differs among the alternative courses of
action
 Relevant Costs – expected future costs
 Relevant Revenues – expected future
revenues
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Irrelevance
 Historical costs are past costs that are
irrelevant to decision making

Also called Sunk Costs
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Types of Information
 Quantitative factors are outcomes that can be
measured in numerical terms
 Qualitative factors are outcomes that are
difficult to measure accurately in numerical
terms, such as satisfaction

Are just as important as quantitative factors
even though they are difficult to measure
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Terminology
 Incremental Cost – the additional total cost
incurred for an activity
 Differential Cost – the difference in total cost
between two alternatives
 Incremental Revenue – the additional total
revenue from an activity
 Differential Revenue – the difference in total
revenue between two alternatives
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Types of Decisions
 One-Time-Only Special Orders
 Insourcing vs. Outsourcing
 Make or Buy
 Product-Mix
 Customer Profitability
 Branch / Segment: Adding or Discontinuing
 Equipment Replacement
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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One-Time-Only Special Orders
 Accepting or rejecting special orders when
there is idle production capacity and the
special orders have no long-run implications
 Decision Rule: does the special order
generate additional operating income?


Yes – accept
No – reject
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-9
One-Time-Only Special Orders
 Compares relevant revenues and relevant
costs to determine profitability
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-10
Potential Problems with
Relevant-Cost Analysis
 Avoid incorrect general assumptions about
information, especially:


“All variable costs are relevant and all fixed
costs are irrelevant”
There are notable exceptions for both costs
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-11
Potential Problems with
Relevant-Cost Analysis
 Problems with using unit-cost data:


Including irrelevant costs in error
Using the same unit-cost with different output
levels

Fixed costs per unit change with different levels of
output
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-12
Avoiding Potential Problems with
Relevant-Cost Analysis
 Focus on Total Revenues and Total Costs,
not their per-unit equivalents
 Continually evaluate data to ensure that they
meet the requirements of relevant information
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-13
Insourcing vs. Outsourcing
 Insourcing – producing goods or services
within an organization
 Outsourcing – purchasing goods or services
from outside vendors
 Also called the “Make or Buy” decision
 Decision Rule: Select the option that will
provide the firm with the lowest cost, and
therefore the highest profit.
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Qualitative Factors
 Nonquantitative factors may be extremely
important in an evaluation process, yet do not
show up directly in calculations:




Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations – distance from
plant, etc.
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Opportunity Costs
 Opportunity Cost is the contribution to operating
income that is forgone by not using a limited resource
in its next-best alternative use

“How much profit did the firm ‘lose out on’ by not
selecting this alternative?”
 Special type of Opportunity Cost: Holding Cost for
Inventory. Funds tied up in inventory are not
available for investment elsewhere
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-16
Product-Mix Decisions
 The decisions made by a company about
which products to sell and in what quantities
 Decision Rule (with a constraint): choose the
product that produces the highest contribution
margin per unit of the constraining resource
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-17
Adding or Dropping Customers
 Decision Rule: Does adding or dropping a
customer add operating income to the firm?


Yes – add or don’t drop
No – drop or don’t add
 Decision is based on profitability of the
customer, not how much revenue a customer
generates
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-18
Adding or Discontinuing
Branches or Segments
 Decision Rule: Does adding or discontinuing
a branch or segment add operating income to
the firm?


Yes – add or don’t discontinue
No – discontinue or don’t add
 Decision is based on profitability of the
branch or segment, not how much revenue
the branch or segment generates
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
11-19
Equipment-Replacement Decisions
 Sometimes difficult due to amount of
information at hand that is irrelevant:


Cost, Accumulated Depreciation, and Book
Value of existing equipment
Any potential Gain or Loss on the transaction
– a Financial Accounting phenomenon only
 Decision Rule: Select the alternative that will
generate the highest operating income
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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Behavioral Implications
 Despite the quantitative nature of some
aspects of decision making, not all managers
will choose the best alternative for the firm
 Managers could engage in self-serving
behavior such as delaying needed equipment
maintenance in order to meet their personal
profitability quotas for bonus consideration
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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